German economy shows signs of slowing

Over the past week, the German economy has shown first real signs of an economic slow-down. Data from the labour market has been much less upbeat than before. Yesterday, also manufacturing orders took a hit, pointing to a further growth moderation starting in the second quarter of 2008. The strong euro and the investment backlash from the tax reform enacted on January 1 of this year are finally felt in the economy.

While the latest slowdown in the reduction of unemployment might well be due to the unusual mild weather during the winter (meaning less lay-offs in the construction sector and hence less re-hiring in the spring), survey data looks much less benign. According to the ifo employment barometer which uses the panel from the ifo business survey and asks managers about their employment plans in the coming months, the employment outlook has fallen to the lowest level since late 2006. While this level still signals some job expansion, the pace is clearly much slower than over the past two years. The employment component of the PMI surveys point in the same direction.

Moreover, the latest order figures are far from good: In seasonally adjusted terms, orders have now fallen four times in a row. Order intake seems to weaken across the board witn non-EMU exports still holding up reasonably well, probably due to the still strong demand in emerging markets.

What is slightly alarming is the trend in domestic orders for new equipment. Since December 2007, this component now trends downwards (see graph). On Eurozone Watch, we have warned repeatedly that the German corporate tax reform enacted on January 1, 2008, might have a dampening effect on investment (see here and here): While the package cut headline tax rates for corporate profits, it also cut the depreciation allowance. Clearly, this has led to some investment being pulled forward into 2007 (which has boosted investment last year, but is now missing in the aggregate demand picture). However, we fear that it might also dampen investment over a more extended period of time as it punishes fast-growing firms with large investments in fixed assets.

The fiscal drag on investment is especially worrisome as demand for new equipment in Germany is strongly related to employment trends (if firms expand their capital stock, they often also hire new workers). Given that the hope for a sustained upswing in Germany still rests on the consumers finally opening their wallets and – given the still rather low wage increases – gains in employment are seen as the main drivers for disposable income, the drop in investment puts the German recovery at jeopardy.

That being said, Germany seems still to do much better than the rest of the Eurozone. While in Spain, surveys among purchasing members are now clearly at a recession level, German surveys still hold up reasonably well. Given the data from production and employment so far, GDP could have expanded by three-quarters of a percent quarter-on-quarter in the first quarter (which would be an annualized rate of 3.0 percent). However, the outlook has clearly clouded. Germany is not a teflon economy.